The Ultimate Stock Selection Strategy: Outperform the Market with Quality and Value

Introduction

Investing in the stock market can seem overwhelming, especially with an investable universe of approximately 60,000 listed companies globally. However, with a structured approach and specific criteria for selection, it’s possible to significantly narrow down this universe to high-quality stocks that not only outperform the market but also offer opportunities for long-term growth at reasonable prices.

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For those who prefer to select individual stocks for the medium to long term, it is crucial to first understand what type of investor you are. To help with this, we have created three articles summarizing the three main types of investors: Value Investors, Growth Investors, and GARP Investors. Additionally, for those interested in passive investment strategies over a very long term (20-30 years), our guide on building a robust ETF portfolio offers comprehensive insights. Furthermore, you can learn more about investing in commodities. Also, check out our article on swing trading, which is an excellent strategy for both individual investors and professional fund managers.

In addition, we invite you to explore our latest article on how to invest in cryptocurrency. This comprehensive guide covers everything you need to know to navigate the exciting world of digital assets. If you want to learn how to unearth cryptocurrencies yourself, we recommend the following book , which details the best decision-making process for cryptographic protocols.

Lastly, you can access our other parabolic growth strategy called biotech strategy. Additionally, you can access our article on the special strategy called Dividend Capture Strategy.

The Power of the Investable Universe

Since 2011, our selected investable universe of companies has outperformed the S&P 500 by more than 5% per year. These companies exhibit better fundamentals on almost every metric compared to the S&P 500. They operate with healthier balance sheets, lower capital intensity, better capital allocation, and higher profitability. Not only have they grown faster than the broader index, but their outlook remains strong.

The only area where the S&P 500 scores better is valuation. This highlights why it’s essential to identify and invest in undervalued companies within this high-quality investable universe. After all, as Warren Buffett wisely said, “It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

The Decision-Making Framework

1. Invest in What You Understand:
The first step in stock selection is to stay within your circle of competence. This means only investing in companies whose business models you thoroughly understand. Knowing how a company makes money, what drives its success, and the risks it faces is crucial. By focusing on companies in industries you comprehend, you reduce the risk of costly mistakes and avoid overconfidence.

2. Look for Wonderful Companies:
Once you’ve filtered companies based on your understanding, it’s time to focus on finding wonderful businesses. These are companies with durable competitive advantages, strong balance sheets, low capital intensity, and excellent capital allocation strategies. They also exhibit high profitability and reinvestment opportunities.

Key indicators for identifying wonderful companies include:

• Revenue growth greater than 7%.
• Earnings growth greater than 9%.
• ROIC (Return on Invested Capital) over 15%.
• Profit margins exceeding 10%.
• Operating cash flow to net income ratio above 90%.
• Net Debt to EBITDA ratio below 3x.

These criteria ensure you’re investing in companies that can continuously grow and reinvest profits efficiently, compounding value for the long term.

3. Focus on Outstanding Management:
Great companies are often led by great managers. Invest in businesses where management’s interests are aligned with those of shareholders. Look for companies where management has significant insider ownership or is still led by its founder. Companies led by managers with “skin in the game” tend to outperform because they are personally invested in the company’s success.

When evaluating management, consider:

• Founder-led companies or those with long-tenured CEOs.
• Insider ownership greater than 10%.
• Minimal use of stock-based compensation that could dilute shareholder value.
• A strong track record of performance.

4. Buy at a Fair Price:
Even the best companies can turn into poor investments if purchased at excessive valuations. It’s critical to ensure that you’re buying at a reasonable price using methods like the Earnings Growth Model or Reverse Discounted Cash Flow (DCF). These models help determine whether a company is undervalued or overvalued compared to its potential future earnings growth.

For instance, by comparing a company’s current forward price-to-earnings (P/E) ratio to its historical average, you can identify undervalued stocks. If the current forward P/E is below its 10-year average, the stock may be underpriced.

To illustrate this approach of identifying undervalued stocks, here are some examples of companies whose current forward P/E ratios are significantly lower than their historical averages. These companies present attractive buying opportunities due to their strong fundamentals and undervaluations, making them prime candidates for inclusion in a well-constructed portfolio:

5. Build a Concentrated Portfolio:
After narrowing down the list to wonderful companies with great management and fair valuations, you can focus on building a concentrated portfolio. Aim for 15-25 high-quality stocks that meet all the selection criteria. A concentrated portfolio of the best companies in the world, bought at reasonable valuations, offers the best potential for long-term wealth creation through compounding.

Valuation Methods for High-Quality Stocks

To evaluate whether a stock is a buy, hold, or sell, three key valuation methods are employed:

1. Forward P/E Comparison:
The forward P/E ratio shows how much investors are willing to pay for future earnings. A lower forward P/E compared to the company’s historical average suggests that the stock is undervalued. For example, Ulta Beauty has a forward P/E of 15.9x compared to its 10-year historical average of 25.6x, indicating that it’s undervalued.

2. Earnings Growth Model (EGM):
This model helps estimate your expected return as an investor by factoring in:

• EPS (Earnings Per Share) growth.
• Dividend yield.
• Multiple expansion (or contraction) based on the valuation change over time.

For a stock to be considered undervalued using the EGM, the expected yearly return should exceed 10%. Using Visa as an example, with assumptions like a 12% annual EPS growth rate, 0.7% dividend yield, and an exit P/E of 26.3x, we calculate that Visa is currently undervalued by 20.2%, making it a compelling buy.

3. Reverse Discounted Cash Flow (DCF):
The reverse DCF model calculates the fair value by determining the multiple you could pay to achieve a 10% return as a shareholder. It uses expected future earnings to determine how much an investor should be willing to pay today for that future cash flow.

The Buy-Hold-Sell List

We categorize the companies within our watchlist into three groups: Buy, Hold, or Sell. This list is updated monthly based on valuation metrics.

• Buy: Companies that are high-quality and undervalued.
• Hold: Companies that are still high-quality but have become a bit expensive.
• Sell: High-quality companies that may be overvalued and, if owned, should be considered for selling.

With this Buy-Hold-Sell framework, you can continuously assess the companies within your portfolio and make informed decisions.

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For a detailed and precise framework (quantitative, qualitative, technical, fundamental), readers can explore our other articles and the following book, which is probably one of the most concise on the topic: The Art of Unearthing Gems in the Stock Market. This resource is perfect for investors of all levels and offers in-depth insights into proven strategies for achieving true success in the stock market. Please note that this is an affiliate link, and we will earn a commission if you purchase the book through it.

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